After reading headlines like “Wall Street faces existential crisis” or “Investment banks braced for a nuclear winter” (both written, I confess, by me) you could be forgiven for thinking that the latest round of earnings from Wall Street banks would make for miserable reading.

Home free? Only three of the 76 prisoners in The Great Escape made it to freedom

Lacklustre activity in financial markets, overcapacity in the industry and an increased regulatory burden would surely mean that profits were going to be, at best, flat to slightly up on a poor 2011.

At first glance, the numbers confirm the idea that the industry is treading water if not slowly sinking. The reported revenues of the big five US investment banks* were down by a few percentage points on 2011 and reported pre-tax profits slipped by about 10%.

Making a break for it

But dig a little deeper and it looks like Wall Street may actually have pulled off the modern day equivalent of The Great Escape – the epic mass breakout by allied prisoners of war from a high-security German camp immortalised in the 1963 film. But as with the movie, digging your way out of trouble is only the start of it.

Behind the headlines, the underlying performance of US investment banks in 2012 (once you strip out the distorting effect of the accounting treatment of the banks’ own debt) was impressive. Overall revenues increased by 10% across the street, all of that cost-cutting finally began to chip away at expenses, and pre-tax profits jumped by two thirds (see chart).

Investment banks even stopped destroying value for their shareholders: the average return on equity across the five banks was just over 13% compared with a miserable 8% in 2011, according to my estimates.

How come? Most obviously, investment banks were saved last year by the fact that the eurozone didn’t blow itself apart nor did the financial markets come to a shuddering halt as they had done halfway through 2011. This relief was felt most obviously in the banks’ fixed-income, currencies and commodities business, in which revenues jumped by more than one fifth last year. With a record year in debt capital markets, fixed income more than offset the slowdown in equities and M&A.

Separately, the picture is clouded by the counter-intuitive way in which US banks account for changes in the value of their own debt – known as DVA or own credit. When a bank’s credit quality falls, it books a profit on the basis that it could in theory buy back debt it has issued at a lower price, and when its credit improves it books a corresponding loss.

Strip this DVA effect out and you get better picture of how a bank’s underlying business is doing. For example, Morgan Stanley’s institutional securities business looks like it plunged to a $1.7bn loss last year. But when you strip out DVA, pre-tax profits more than tripled to around $2.7bn. On this basis underlying pre-tax profits at the big five US investment banks increased by 68% last year (instead of the reported fall of 10%).

But before anyone gets too excited, investment banks – and in particular US investment banks – are some way short of the trees still. First, while the industry has rebounded strongly from 2011, it still doesn’t have much to write home about. Pre-tax profits and profitability are still lower than in 2010 and scarcely half the levels achieved as recently as 2009.

Still a long way to go

Despite the recovery, some of Wall Street’s biggest beasts are still struggling to deliver a net economic return for shareholders (that is, above their cost of equity). Goldman Sachs says that its return on equity of about 11% is “hardly aspirational”, but at least it is double where it was a year ago and nearly double that of Morgan Stanley’s institutional securities business.

Second, the outlook for revenues does not look rosy for 2013. While debt markets have come bursting out of the blocks in the first few weeks of this year, many bankers are getting nervous that the markets might collapse under their own weight, and they’re forecasting DCM and FICC revenues will fall this year. If they do, the gap is unlikely to be filled by equities or M&A, both businesses where any increase in activity is likely to be offset by declining margins.

With revenues flatlining, costs are proving remarkably stubborn. Overall costs fell by just 2% across Wall Street despite the rounds of cost-cutting. A (very small) sample of three investment banks that disclose what they pay their staff, found compensation costs fell last year by – wait for it – 0.19%, and non-compensation costs rose.

The danger of arrest

Perhaps more importantly, US investment banks will face tougher capital requirements this year and next as the gap in regulatory implementation between the US and Europe slowly closes. As the industry stumbles towards Basel III, US banks will be forced to reassess the profitability of some of their fixed-income and trading business, causing the same sort of chaos as it has on this side of the Atlantic.
Most likely this will have the double-whammy effect of hitting profits and increasing the amount of equity that banks allocate to their business. To avoid slipping back into single-digit returns again – or to ensure you ever get out of them (I’m looking at you Morgan Stanley) – US banks will have to be much leaner and more nimble by the end of this year.

Wall Street’s finest may be in better shape than they look, but are not quite as healthy as they would like. Which brings us back to The Great Escape. Don’t forget that two-thirds of the 76 prisoners who escaped were rounded up and shot, and just three of them made it safely to freedom.